The investment landscape last year was stained with the red ink of many a stock fund last year. Even value-oriented funds, on average, lost ground—despite their comeback during the prior two years.

But there remain bright spots in fund performance.

One fund that fared well last year, as well as over a very tough three-year period, is the Yacktman Fund. The fund follows an approach that combines growth and value, investing in growth companies at what it considers to be low prices.

In 2002, the fund returned a handsome 11.4% at a time when the S&P 500 was down a hefty 22%. The fund is among the top 25% of its category for the last one-year and three-year periods through year-end 2002.

Currently, the Yacktman fund has about $293 million in total assets.

In late December 2002, Donald Yacktman, president and portfolio manager of the fund, discussed his approach with Maria Crawford Scott.

What is the investment objective of the fund?

Our goal is to get returns above the S&P 500 while taking on less risk. However, we do invest in all areas of the market—were basically a multi-cap value fund.

Our strategy is like our logo, a triangle, with three basic attributes: We like good businesses, ones we can buy at a low purchase price, and that have good, shareholder-oriented management.

First, we like to find good businesses. We define a good business as a business that has one or more of these characteristics: It earns a high return on assets, it has a high market share, it has relatively low capital requirements, and it has unique franchise characteristics.

Another way to look at it is to look at what we dont own. We dont own businesses that have a lot of fixed assets, or that have a lot of economic sensitivity or volatile earnings—for instance, airlines, automobile manufacturers, and technological capital goods firms like Cisco. We like to go the other way. We particularly gravitate toward businesses that are more predictable and have lower asset intensities. For example, the biggest holding we have is Lancaster Colony, primarily a specialty foods company. It has a down year in earnings maybe once in a decade, plus it has a high return on assets, lots of insider ownership and 39 years of rising dividends.

The second part of the triangle is a low purchase price. We like to buy companies cheap, and we have a lot of low P/E (price-earnings ratio) stocks on our list. That doesnt mean that we buy a stock because it has a low P/E, but our holdings do tend to have low P/Es most of the time.

The third part of the triangle is that we like to see a management thats objective and works to build the company. In other words, the managers are good capital allocaters. We feel managers have five basic decisions with their cash. First, they can put it back into the existing business to try to improve and grow the crown jewels. Second, they can make synergistic acquisitions—acquisitions where they dont overpay and it fits in with the overall business. Lancaster Colony has basically built up their specialty food business gradually by doing just that. Third, a company can use its cash to buy back shares. Lancaster has done some of that, and a number of our other companies are cash generators to the point that they buy back shares.

Were less enamored with the fourth and fifth ways to use cash. Fourth would be to pay down a debt. The only time you really want to do that is if youre overleveraged and you need to reduce the debt to get your credit position enhanced. Fifth would be to pay a dividend. Since dividends are currently double-taxed, were less enamored with that—wed rather see managers putting the money in the first three categories.

The way you judge management, then, is by seeing how they make those five decisions when allocating capital?

Yes. Think of it conceptually. A common stock is really very similar to a bond except that you dont know what the coupons going to be. If youre a long-term investor, the person who is reallocating those bond coupons to make returns on them becomes pretty important over a period of years. If youre only owning them for the short term, it doesnt matter much. Thats the idea. Lancaster fits the ideal pretty well when you look at all three parts. Not all of our holdings do.

You said that you dont necessarily look at price-earnings ratios. What do you use to value a stock?

When you value a business, what you really ought to do is value normalized operating income. Then you need to, in effect, unleverage the balance sheet and look at the debt and the equity together, to see what the total is that you would be paying for it. As an example, suppose you have a company with $100 million in pretax operating income, and it has a market cap of $800 million in equity and another $200 million in net debt—together, thats $1 billion, so in effect you would be paying 10 times the net operating income for that company. This method allows you to look at everything across the board, and be more objective about how you value a company.

On the other hand, there is a high correlation with our portfolio and low price-earnings ratios. Every month we update our portfolio, put it on the Web site, and show a weighted average P/E. What we end up with is a portfolio of above-average companies for which weve paid below-average prices.

Does your approach mean that you tend to favor companies in particular industries?

We obviously favor businesses that have certain characteristics—most of them are low capital-intensive businesses. Sometimes well have some that are more capital-intensive but are relatively predictable. One of our major investments is in Qwest, but not the common stock—were in the bonds. We think of the bond as really being an equity and the common as being more like an option. Qwest went from $60 to $1 or $2. But if you look at Qwest as a business, its very much like the old U.S. West, but youre paying about half of what youd pay for SBC, or a Verizon, or a Bell South. We just happen to like the one that has less risk in it—which is these bonds. They still have about a 20% return to maturity—they are 7.9% coupons until 2010 selling at about 50 cents on the dollar.

What was the reason for the low price?

The company bought U.S. West and theyre also in some other businesses, some of which have turned out to be poor. But they are getting back closer to what the original U.S. West was.

When a stock has a low price-earnings ratio, often it is because the market has low expectations for it. Do you typically know where your disagreement with the market is?

Yes. Every company has a ledger that contains positives and negatives. When stocks are going up and the media write about them, they write about all the positives and usually dont tell you about the negatives. When the stocks are going down and they dont like them any more, they tell you about all the negatives, but they dont tell you about the positives.

Theres no substitute for knowledge and nobody has all the answers. In this business youre wrong every day because you never buy at the bottom, and you never sell at the top—its just a matter of degree. Anytime that we buy a stock, were buying it with the idea that we can own it as far out as the eye can see—as long as it doesnt get overvalued. Were not trying to buy something that we can be cute about and sell two weeks from now. We just try to be objective.

The fund tends to be concentrated in certain stocks.

The Yacktman fund can have up to 25% of the portfolio in positions over 5%. I also manage a Focused fund that can have up to 50% in positions over 5%.

Right now, weve got over 25% in the top four holdings, but that is due to price appreciation, and you can only do that if it comes from appreciation. We also have over 45% of the fund in the top 10 holdings. We may have a lot of stocks, but you should look at where most of the money really is.

Our theory is that if you have a good business, why dont you want to own a lot more of it? And if its a real bargain—the juicy ones, the fat pitches across the middle of the plate—those are the ones you want to have the most money in. The four big ones in the fund right now are Tyco, Liberty Media, the Qwest bonds and Lancaster Colony.

You mentioned that one objective of the fund is lower risk. But some people would consider less diversification as more risky. How do you define risk?

The more diversified you get, the closer youll end up with returns close to the S&P 500. Were clearly not indexers. If an investor wants to do that, they might as well buy an index fund.

I think risk is how much youre going to lose in permanent capital. What I feel most comfortable with in our funds is the fact that, at the end of August, our investors were virtually at their all-time highs. I dont think there are too many other funds that can say that. And, in the past three years, all three years weve been up: 2000, 2001 and 2002.

It appears that typically you gradually move into large positions—you start buying a stock and then slowly it becomes a larger and larger holding.

Yes, thats typical. A good example of that would be Tyco. We bought a thimbleful in the teens, and then when it got down to $10 or below, we just backed up the truck. We felt that at that price, were ready.

On the other end of it, what would prompt you to sell?

Well when we feel a stocks no longer a good value. Part of it is a function of what its value is relative to other things out there. Sometimes you have to make calls between two stocks that you like. If the spread gets to be big enough where you feel that this one is a much better deal than that one, then well make the decision to go sell one in order to buy the other.

What about on the downside, if a stock is not playing out as you expected?

Usually what happens is that you get new information and you need to adjust the values accordingly. If youre wrong and the companys not worth $50, its worth $45, then you ought to adjust the value down and be objective.

When we make a decision on a company, part of its relative to other companies, part of its relative to cash—but its not mechanical. For instance, some investors say they wont buy a stock until it gets to two-thirds or 75% of what they think its worth. Well, that sounds good, but what if you paid 80% of what its worth and you beat Treasuries in the process. Wouldnt you be better off? Its really capital allocation. You might be better off doing that and then waiting and keeping that particular position until something else comes up and you can say, all right, at this point Id rather sell it and buy this other because this is at 50% of what its worth. Its a matter of relative value.

Are there any examples of companies that you have been wrong about?

I can give you a few examples. Fruit of the Loom and Reebok were pretty disastrous situations. In the case of Reebok, we were able to make a lot of it back with some other shoe companies—K-Swiss being one of the investments.

But with Fruit of the Loom, who would have thought that a company with a 40% market share would have had the manufacturing problems they did when they took it overseas? They made terrible management decisions, and they basically blew the company. Those situations are rare. Usually if you have a good business with attractive managers, then usually the businesses will stay good. That was one we should have analyzed differently in hindsight, no question about it. But our record is not a function of each individual decision, its the overall decisions. And if you look at the overall record over the last three years in our category, I think were right at the top right now.

Is the fund always fully invested?

No. Its just a function of whats out there and how excited we are. If we think well beat Treasuries by enough of a margin and we feel comfortable with the quality level, well buy a stock. Our cash position does vary. Right now weve got 14% in cash in the Yacktman Fund.

Whats your market outlook?

I dont really have any. The best thing I can tell you is that if you take the S&P normalized earnings for 2003, which we think will be around the 48 level, and if interest rates stay where theyre at, that gives you a price-earnings ratio of about 20, which gets the S&P to roughly 960—not too far from where we are now. So the market right now is around what you would think of as equilibrium. But you can also see that over the last few years the S&P stayed way above what the normal equilibrium would have been. And you can have periods where it will go way below and stay there. Thats why I think that to try to predict where the market is going is folly.

Were not buying the S&P, so why worry about it other than to try to have some sort of backdrop? But I dont care what it does day to day. Volatility is our friend. Volatility creates value and it also creates selling opportunities. Thats fine with us.

→ Maria Crawford Scott

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In This Issue

February 2003 Issue

Asset AllocationFive Big Lessons From Market HistoryThe period from 1987 to 2002 encompassed the extremes, including two severe bear markets and one long bull market. How would various asset allocation strategies have fared during this time period? A valuable financial market history lesson.

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